Every year around this time I talk to my tax person about putting money into an IRA (Individual Retirement Account). He tells me whether to invest in my traditional IRA or my Roth. I thank him, put a note in my to-do list, then google “the difference between traditional and Roth IRAs” to remind myself which one is which. Since I’ve already done the research this year, I thought I’d share some of the things I learned:
First of all, the main difference between traditional and Roth IRAs is when the money is taxed. The traditional IRA was created to give individuals an incentive to save for retirement. When contributions are made to these accounts, they’re tax-deductible. The money is taxed later when it’s withdrawn, typically during retirement years.
Money that goes into a Roth IRA has already been taxed. It doesn’t save on your current year taxes, but withdrawals are then tax free in retirement (with some restrictions). You can see why you’d want some good advice to determine which type of account is best for you, since it will impact your current or future taxes. Keep in mind that your strategy will likely change over time.
IRA fun facts
Now, just for fun, here’s a little bit of IRA history and a little bit of politics:
Both traditional and Roth IRAs were created by congress as a combination of consumer protection and tax policy. Traditional IRAs were embedded in a 1974 law regulating employee pensions after some high-profile pension fund failures. The Roth IRA came into being 23 years later, in 1997. It’s named after Senator William Roth of Delaware, so you can stop wondering what “Roth” means.
It kind of makes sense now that there’s this yin-and-yang of retirement accounts, one pre-tax and one after-tax. But actually the Roth IRA came from a political compromise. Senator Roth was trying to resuscitate the traditional IRA which had fallen out of favor due to deductibility restrictions imposed by the Tax Reform Act of 1986. Under congressional budget rules, the cost of giving an IRA tax break to everyone was too high, so they put income limits on deductible IRAs. Since Roth IRAs are taxed at withdrawal, the cost to the government was shifted outside the 10-year budgetary window. Ah, politics.
Ask the experts
Like anything invented by government and born of compromise, IRAs have their rules and complications. My advice: Get good advice. Here are a few things you’ll want to ask a professional about:
- Juggling traditional and Roth IRAs. For everything there’s a season. Knowing when and how much to invest in each type of IRA will depend on factors like your age, income, investment strategy, and what kind of plan your employer offers.
- Approaching retirement. IRAs have rules about when you have to withdraw funds from your IRA (starting at age 72) and when you can make withdrawals penalty-free (age 59½ with some exceptions). Be sure you’re staying on the right side of the law.
- Rollovers and Roth conversions. There are ways to move funds between retirement accounts that can help with your investment and tax strategies. Your best bet here is to make sure your financial planner has a full picture of your finances so they can advise you.
- Inherited IRAs. I found out recently that you can inherit IRAs, but inherited IRAs have their own rules. How you handle them depends on your relationship with the person who named you as beneficiary—whether they were your spouse or non-spouse and when you inherited it.
The main point here is that something seemingly simple (pre-tax, after-tax) can get complicated. Your Arrivity financial planner will build IRA strategies into your financial plan. If you’re thinking about changing your goals—like planning an early retirement or purchasing a first home—find out how that will impact your IRAs.
More IRA things to think about:
- Do you have young adults in your family? Be sure to advise them about the importance of saving for early for retirement. This can mean maximizing their employer plan or opening an IRA. You might consider gifting them enough money to make an IRA contribution.
- Anyone over age 70½ can make tax-free charitable contributions directly to qualified charitable organizations from their IRA. It’s another way to manage your taxes.
- Early withdrawal from an IRA comes with financial penalties unless it’s under certain defined conditions. Again, get good advice.
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Liz is a Late Boomer in the sandwich generation who started an independent writing and brand consulting practice after years as a senior marketing executive. She lives in Seattle, Washington. Her mother lives nearby and her daughter is a recent college graduate.
The foregoing content reflects the opinions or perspective of Liz Behlke and/or Arrivity financial planners and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful. Arrivity does not give tax or legal advice. Tax and/or legal strategies should be discussed with a professional before implementing.